The risks and rewards of equity crowdfunding

Crowdfunding is hot and about to get hotter. The new phenomenon—it traces only to 2006—allows a group of individuals to co-fund a product or company in exchange for early access to products, funder-only goodies (Fund a rock band! Get a signed copy of the new album!), and the satisfaction of supporting an innovative or exciting new venture.

The craze is making brand names of Web sites like Kickstarter and Indiegogo. And do-it-yourself inventors and entrepreneurs are getting projects off the ground without the help of traditional funding sources like venture capital.

Now the early supporters of crowdfunding startups may see real financial returns as well. The Securities and Exchange Commission is working on rules that will progressively allow entrepreneurs to use crowdfunding to sell equity in their companies. Investors no longer just get first shot at a product. Now they can also get an ownership stake. The first set of rules go into effect Sept. 23.

Christian Catalini, an assistant professor of technological innovation, entrepreneurship and strategic management who joined MIT Sloan this fall, is eager to see just what happens.

Catalini, who joins MIT Sloan from the University of Toronto’s Rotman School of Management, has studied crowdfunding almost since its birth. In equity-based crowdfunding, he sees a journey of risks and rewards.

“The utopian view is that this will revolutionize how funding is done and will democratize funding,” said Catalini. “My sense is we’ll see a lot of experimentation, and some spectacular failures because people are usually optimistic when technology changes come about. And some people will say it’s not going anywhere.”

But Catalini said that, given time, equity crowdfunding will thrive, particularly for accredited investors.

“At first, Amazon didn’t seem to change anything,” Catalini said. “Now a lot of people would have a hard time thinking about not buying a book through an online system.”

Kick-starting equity crowdfunding

The federal JOBS Act—short for Jumpstart Our Business Startups—opened the door for equity crowdfunding when President Obama signed it into law in April 2012. It scrapped the Depression-era prohibition against private companies marketing stock directly to the general public. Now, accredited—prescreened—investors with annual earnings of at least $200,000 or liquid assets of at least $1 million will be deemed “sophisticated” enough to participate. They will be the first into the equity-based crowdfunding pool.

The government sees crowdfunding as a job creator for several reasons, Catalini said. First, it expands the pool of capital available to companies. Second, there is an assumption it will broaden the diversity of projects that get early stage capital. Currently, entrepreneurs with track records are more likely to catch the eye of an investor. The “crowd” may finance an unknown start-up with a good idea that traditional funders miss.

“There’s a whole culture of entrepreneurs growing in key spots,” Catalini said. “Crowdfunding is seen as just one more way for these people to get funded.”

Catalini has been studying crowdfunding since its 2006 origins with Sellaband, a website founded in Amsterdam that allows musicians to raise money for recording directly from their fans, often in exchange for the finished record. The site is “the grand-daddy” of crowdfunding, Catalini said. Similar sites, most notably Kickstarter, followed in the U.S.

Earlier this year, Catalini and colleagues in Toronto, professors Ajay Agrawal and Avi Goldfarb, examined the possible effects of equity-based crowdfunding in a paper, “Some Simple Economics of Crowdfunding.” In it, they write about entrepreneur and inventor Eric Migicovsky, who turned to Kickstarter in April 2012 seeking $100,000 to manufacture Pebble, a watch that interacts with Android and iOS devices. Pebble attracted attention and, to Migicovsky’s surprise, raised $10 million.

Migicovsky was quickly underwater, having committed to producing 85,000 watches and delivering them within five months, a daunting target. That didn’t happen, but the popularity of Pebble helped Migicovsky land a round of traditional venture capital.

“There’s a lot of experimentation going on about the way new ideas are funded,” Catalini said.

Entrepreneurial headaches ahead?

“If you live in the Boston-area or Silicon Valley and are not a first time entrepreneur, you’re not going to raise money with crowdfunding,” Catalini said. “The value you get from interacting with angel investors and VCs is more than anything you could get from a crowd of individuals online. But if you’re a group of students [from elsewhere] with no track record, you may try and see if you can raise funds.”

But every investment has a risk, and the fear of failure or fraud could be greater for inexperienced investors. In traditional crowdfunding, an entrepreneur may not complete his or her project, leaving benefactors with no product and little recourse. The stakes are higher when someone has bought stock in a company, Catalini said. And unlike in venture capital deals, where investors have significant insight and input into companies they fund, those who invest through crowdfunding may be left in the dark about their company’s operations and progress. That, he said, could prevent equity crowdfunding from taking off.

“If you can’t separate good projects from bad ones—because there’s fraud, the creator is incompetent, they can’t bring product to life—that might unravel the market,” he said.

Entrepreneurs also have market headaches ahead. Instead of answering to a group of people who essentially pre-paid for a product, with the equity-based approach they become the head of a stock company. If they fall behind delivering product, they answer to shareholders. They also risk sharing proprietary information with a large group of untrusted and untested investors. Simply using equity-based crowdfunding gives competitors a heads-up on a new product and the company’s financial situation.

And then there’s the risk of significant, high profile failures. The potential for early equity-based crowdfunded companies to fail could scare away investors and bury the idea before it has a chance to realize its potential, Catalini said. That, he said, is why the SECs rules are critical.

The SEC continues to work on sections of the rules. There’s considerable tension, Catalini said, over a provision that would bar a company that violates the rules from soliciting again for one year, a potential death sentence for a young company. Catalini said entrepreneurs and funding platforms are seeking less restrictive requirements.

Another provision entrepreneurs and investors are waiting for—one Catalini called “key”—would expand the current definition of an accredited investor and open these enterprises up to general investment.

“The SEC wants to make sure the consumer isn’t harmed,” Catalini said. “We’ll see an interesting back and forth as the regulations are released.”